Pages

Japan, the ultimate contrarian trade

Japan, the mere mention of the country for investors elicits disregard and apathy. Mention a company in the UK trading for less than net cash and growing earnings and interest explodes. Mention a company in Japan with the same metrics, and investors come up with reasons to not invest. Japan is a fascinating place, a first world country, ultra modern, yet for investors something less than a third world market.

In 1939 John Templeton called his broker and asked him to buy $100 worth of every stock trading for less than $1, bankrupt or not. His broker obliged, grudgingly and purchased 104 stocks for him. That initial $10400 turned into $40,000 four years later, and got John started on his investment career.

In retrospect John Templeton's trade seems obvious, yet at the time is was something only an investor a few slices short of a loaf would undertake. I think we see the same dynamics with Japan today.

For most investors Japan is a place where money goes to die. Japanese bonds are famous for their widow maker trade, and Japanese equities have destroyed a few legacies themselves. No self respecting investor takes a chance on Japanese equities, which have been in a bear market for the past 20 years. A mention of a purchase in Japanese equities is usually met with a response that Japan is about to enter hyper-inflation, or the Yen is going to be destroyed, or the country is about to default on their debt. I don't want to minimize the finances of the Japanese government, but these characterizations have been going on for the past decade or more. That's not to say they won't come to pass eventually, but a lot of people have lost a lot of money trying to guess the timing. Eventually Japan will have to deal with their debt problem, but so will the US, and so will Europe, so Japan is not unique in that regard.

So with all this I want to introduce what I call the greatest Japanese trade ever.

Long time readers know that I've toyed with the Japanese net-net market. I've done numerous posts on Japanese equities, and even bought a few Japanese net-nets. Each time though I keep coming back to the same problem, there are so many Japanese net-nets, how do I choose the ones to invest in? I've translated financial statements in an effort to pick the "best" cheapest companies. I've built out spreadsheets of various metrics, yet I've never had the feeling that I'm fully capturing the cheapest companies. Do I purchase the ones at the lowest P/NCAV, or the ones with the highest ROE, or the ones with the best dividend yield? I really don't know what will work the best in the future.

In thinking about Japan I've started to think about the John Templeton approach. I've often thought that if I could buy ALL of the Japanese net-net's I'd be happy. Sure, some would go bankrupt, but who cares, some would also quadruple. I've told a number of investors that I'm convinced that someone buying the cheapest Japanese companies could not go wrong. The trade might not work out over the next four to six months, but over the next four to six years it would for sure. Why do I think this? Because it's absurd that profitable companies are selling for less than net cash, or less than net current assets.

I've thought about this trade a lot, buying all the net-nets, the problem is one of both capital and commissions. As of today there are 448 companies selling for less than NCAV, and with the funky Japanese rules regarding lot sizes, I estimate it would take close to $4.4m to buy every single one of these companies. I don't have anywhere near $4.4m in capital, and at my broker the commission to enter an exit each trade would be a serious hamper to results.

Recently I found out that Schwab created a new Global Trading product as part of their brokerage account. As a promotion for this new account they're offering free trades until March 2013. Free trades on international equities got my attention, I started to think that maybe the ultimate Japan trade might be possible.

While Schwab trades all Japanese exchanges (Tokyo, Osaka, JASDAQ), they only trade securities where they offer an equity rating, which is 882 equities.

Using the Schwab platform I'm hoping to pull my own mini-Templeton trade. I'm looking to buy 20-30 Japanese net-nets, in addition to the four I already own. Doing this will more than double my exposure to Japanese net-nets.

So here is the plan: I am going to open a Schwab account and purchase 20-30 Japanese net-nets. I'd like to purchase more, but my capital is already tied up in other great opportunities, and this is the most I can spare at this time. I'm going to also hedge my exposure to Yen with a future or options in case of a Yen explosion. This way I'll still get the market return these net-nets provide, but won't have to worry about the Japanese debt problems. My hope is that I can forget about this account for three or four years, and at that point I'll have at least 2x my money if not more.

Some readers might wonder exactly how I'll pick 20-30 companies out of 448. I'm going to approach this in a similar fashion as John Templeton. I'm going to start with the lowest priced equities first before layering on any other criteria. My second criteria will be discount to NCAV, my third criteria, discount to BV, and my fourth criteria ROE ex-cash. I also want each of my holdings to pay a dividend, so I'm paid to wait this out.

37 comments:

Hi Nate,Interesting idea. One of the issues I often find for myself, when buying an index or even a mutual fund is - exit strategy. Is this something you have already thought of or for that matter are even concerned with? When I buy shares of distict companies, I try to base if off my what I believe the shares are worth. Will you do that here for all the companies you purchase?

This is a really good question, and honestly I haven't thought much about it. My initial reaction is I'd sell when these stocks reached NCAV or book value but constantly monitoring that might be a hassle.

In theory the way this should work would be that I constantly recycle the capital. So I sell each company as it hits NCAV or BV and invest that money in another net-net, constantly staying invested.

You'll probably get in the habit of "recycling" capital, especially because many of your picks will pay dividends as well. But it probably is worth adding a column to your spreadsheet of what NCAV or BV is in a per/share price, so you can monitor it periodically.

I think MSN money will let you add all your picks to a portfolio on their site. It's annoying to have to create an MSN login (who even uses MSFT web products anymore?!) but that could be one free, relatively easy way to at least keep tabs on what the companies are doing price-wise.

Much harder is noticing when the quality picture deteriorates substantially. Then again, that's to be expected with net-nets, so I guess you just buy and wait for them to appreciate, you don't do anything if the business deteriorates.

Psychologically, how would you feel and what kind of personal reaction would you anticipate from yourself if you woke up one day and the Yen had fallen 20-25% against the dollar and you weren't hedged? 50%? 75%?

One issue longer term is that you are buying equities in another currency. While the Yen has been one way for 20+ years, what if that changes drastically? Japan is a different world, but would be an interesting exercise.

There's always currency risk when investing overseas. My portfolio is already loaded with currency risk in the form of Yen, Pounds, Euros, Francs.. But I also have another currency risk, that's being super concentrated in dollars.

I could reverse your statement and say "While the Dollar has been one way for 20+ years, what if that changes drastically?"

So dollars are a risk as well. Either way I've decided for this trade I'm going to hedge my exposure to Yen. I mentioned it in the post, but maybe didn't call it out enough. I don't hedge any other currency, but I'm expecting the Yen to fall, maybe to the 100 or 110 level. I don't want to get caught in a situation where the companies do well, yet I lose money on the currency.

Yes, this is the problem. Schwab offers futures on currency, but I believe a future is denominated in $100k chunks. So I'd be hedging $100k of Yen exposure, but my actual exposure would be less. I'd also open myself to the potential for a large loss if it moves against me.

I was thinking of the short the yen ETF, I've also been thinking of doing something something with options. The easiest is buying puts, but the problem is I'd have to deal with time decay, option premium etc.

The CME trades an e mini Japanese yen future that has a notational value of about $60000. If that is still too much you could always buy in the money puts in the yen ETF thus eliminating most of the time decay.

One question here is what is your timeline? In the short run, currencies can be volatile. In the long run, currencies tend to be more stable against one another.

What if you just permanently commit part of your portfolio/capital to Japan/the Yen? This essentially eliminates the currency risk because you're now investing just like a Japanese person-- whatever happens to the Yen, that's the currency you're making investment decisions in. The Yen could have some trouble over time but in the long-run, Japan will still be where it is and its assets will be in place. As the portfolio matures you could roll the new cash into other JNets or other cheap, high quality assets that are Yen-denominated.

The real risk here is not the currency risk, it is the inflation risk. If you were buying a bunch of real assets for cheap, you wouldn't really care what happens to the Yen so much because you'd assume in real terms your earnings power and asset values would be approximately the same over time, whatever unit you used to account them in. But because you're buying piles of cash and short-term, liquid current assets, the risk of a large loss in purchasing power in the short-term is real because cash is not an earning asset (especially not w/ Japanese rates where they are)... and these businesses don't appear to have profitable places to put excess capital.

One way to "hedge" the downside of the yen exposure is to filter for export-centric companies, whose products are sold and priced on worldwide markets. It's win-win: if the yen goes down not only does the revenue increase in yen terms, but the cost base shrinks if they have significant Japanese inputs.

If you take this option would be nice to see what list you end up with!

I had two people send me screens of all Japanese net-nets, so the pool is shrunk in that regard. Beyond that I'll probably look them up on MSN for history of profitability, and dividends. I also want companies without debt.

I went through and scored 100 companies in the past like this. I'll be doing something similar now. So I'll sort by the lowest share price, then within that take the ones that meet the simple scoring and buy.

I used MSN Money, it's helpful because they have good balance sheet detail and they have helpful 10yr summaries of earnings and basic balance sheet items.

I liked the scoring system you used originally, which is why I partly adopted it myself. However, the dividend point is a little... flim-flam... because companies can cut dividends any time they want. In general, it's better to buy companies that are cheap which tend to pay dividends, not to buy a company because of its dividend.

That being said, I wonder if you've since considered any new criteria to add to your "scoring screen"? For example, I wonder if a company should get a point for maintaining/increasing its earnings over 10 yrs, whereas one with a declining earnings picture gets a 0?

Can you think of others you might add as a "quality test" to your scoring system?

I was a little confused by your last paragraph. Are you saying that a company trading at 2x BV and 25x earnings at a price of Y1/share would be picked before a company trading at 10% of NCAV and 2x earnings at a price of Y100/share?

Or are you saying you're going to buy the lowest share-price out of the list of net-nets you have access to via Schwab?

Sure, so the first pass is lowest share priced stocks. Then the second sort is cheapness, then after that I'll look at earnings or dividends or something. So a stock selling at ¥30 will get priority over one at ¥4000.

Maybe a better way is to determine ultimate cheapness then take the lowest priced stocks from that bunch, that might be a better approach.

But you've decided to focus on the lowest price as opposed to "cheapest" (which, in and of itself is a cloudy term, I admit), simply because this is what Templeton once did? Or is there some causal relationship in your mind between low share prices and investment outcomes?

If this strategy would work, are you also building a basket of penny stocks in the US?

Yes, Templeton and Graham, in SA there is a chapter discussing low priced stocks, they have more potential. I think the better approach is to look for ones that are cheapest first then lowest price in that.

In some ways just going lowest share price first might be a nice selection mechanism to get a good cross section of companies.

But "more potential" from the standpoint of a small increase in price in absolute terms (say, Y1 to Y2) is a doubling of your money?

I forget this part from Graham. I'll be rereading it soon so I'll keep an eye out but it's somewhat curious to me. Again, I am not sure why, if this is a good heuristic, you wouldn't routinely buy penny stock baskets in the US...

Yeah, the theory is it's easier for a stock to go from $1 to $1.50 than from $100 to $150. Sure it's the smae percentage, but there is a psychological thing about small numbers. On that same stock someone would probably pay $1.01 to buy because it's only a penny more. Yet $101 is a dollar more. Yes the same, but a dollar is greater than a penny.

I'm not arguing it's logical, but it's how people see things. I do have a preference for lower priced stocks in general. I don't want penny stocks, but I'd prefer something in the $5-15 range verses the $50-100 range. Total value the same, but I like the lower price, not sure why.

I am not trying to beat a dead horse here or be pedantic but, if we WERE trying to make this idea logical, wouldn't it be logically consistent to start by assembling a basket of penny stocks in the US and then making decisions about other factors such as quality or perceived cheapness from there?

I am honestly asking to make sure I am getting the point here... it seems like that is the logical extreme of this idea but I have a hard time accepting the idea of anyone, let alone Ben "Business-like" Graham, suggesting you buy something simply because it's the lowest price thing. I understand he's making a psychological commentary but then that would seem to be a different thing than recommending or predicating an investment operation off of "lowest price X" as the first screening criterion.

Yes, the minimum lots are what really complicates this. The problem is buying small or smallish lots isn't possible for some stocks. Some stocks have a minimum due to lots ranging from $5k to $10-15k or more. That's why an equal sizing strategy buying all the net-nets is a problem. The position size would have to be determined by the largest lot minimum, which could be substantial.

Don't forget the 2000 JPY/trade commission when you eventually sell... IB now has a 80 JPY/trade (i.e. $1) minimum commission, but only TSE stocks.

If USDJPY weakens substantially, then Japanese exporters will have earnings coming out the ear (and see this reflected in valuations, e.g. this March). Incidentally, several of the NCAV or P/B based basement-bargains are exporters (or plug into an export-chain). Thus, if the JPY strengthens, you are holding more valuable assets; if the JPY weakens, you are holding more valuable earnings; no hedging needed. And this is when I back the truck & load up to the hilt...

Are you making the argument that this is a "risk-free trade"? That you win no matter what happens?

If the Yen strengthens, then earnings weaken while asset values strengthen-- but they have to strengthen more than earnings weaken to come out an intrinsic value winner, and the market has to be more concerned with asset values than earnings values to reward you price-wise.

If the Yen weakens, then earnings strengthen while asset values weaken-- but they have to strengthen more than asset values weaken, etc. etc.

I don't think there's a free lunch here.

Besides, asset values are tied to earnings power and vice versa, it's confusing to think they could move inversely of one another. "Yeah, the assets of my business are worthless but boy do they ever generate valuable earnings!!"

Not a bad idea, but just as people have been saying Japan must face its debt demons (for over a decade), people have been saying Japanese stocks trading below NCAV must gravitate upwards (for over a decade). They're both true, but the question is when?

Nate have you look at Interactive Brokers? There Japan stock commissions are .08%. They also don't ding you the 3% or so currency fee that I remember Fidelity had. It is easy to hedge the yen risk with CME futures through IB, the big contract JPY is for 12.5mm yen and they also have a half size contract, symbol J7. IB only has Tokyo stock exchange stocks which does somewhat limit the selection of micro caps.

I don't know whether this is a really stupid idea for hedging the yen-exposure, but you could buy your stock in yen on credit and have the corresponding USD amount as balance in your account. Yen interest rates at IB are currently at 1.593%, so the cost per year isn't too big and you don't have to worry about rolling over futures/options etc...

There are 2 strange things I experienced when investing JP equities.(1) Deep value works better than other developed markets.(2) Profitable companies (ROE, ROIC) in general turns out to be bad investments and under-performs low profitability names.The second observations really confuse me. Do you have idea about it?